An efficient capital market is a market where the share prices reflect new information accurately and in real time. Capital market efficiency is judged by its success in incorporating and inducting information, generally about the basic value of securities, into the price of securities.
This basic or fundamental value of securities is the present value of the cash flows expected in the future by the person owning the securities. The fluctuation in the value of stocks encourage traders to trade in a competitive manner with the objective of maximum profit.
This results in price movements towards the current value of the cash flows in the future. The information is very easily available at cheap rates because of the presence of organized markets and various technological innovations. An efficient capital market incorporates information quickly and accurately into the prices of securities.
In the weak-form efficient capital market, information about the history of previous returns and prices are reflected fully in the security prices; the returns from stocks in this type of market are unpredictable.
In the semistrong-form efficient market, the public information is completely reflected in security prices; in this market, those traders who have non-public information access can earn excess profits.
In the strong-form efficient market, under no circumstances can investors earn excess profits because all of the information is incorporated into the security prices.
The funds that are flowing in capital markets, from savers to the firms with the aim of financing projects, must flow into the best and top valued projects and, therefore, informational efficiency is of supreme importance. Stocks must be efficiently priced, because if the securities are priced accurately, then those investors who do not have time for market analysis would feel confident about making investments in the capital market.
Eugene Fama was one of the earliest to theorize capital market efficiency, but empirical tests of capital market efficiency had begun even before that.
Last Updated on : 23rd June 2015